All eyes on inflation

The big question for 2018

How much inflation will we see in 2018? Inflation will ultimately determine the number of interest rate increases, the extent of upward yield pressure at the long end of the curve, and the duration of this economic expansion. Opinions on inflation vary considerably, not least because inflation has confused many during the current economic expansion. But the game will change in 2018 with the implementation of late-cycle stimulus, which has not previously been previously attempted. Typically, such a stimulus occurs during a far weaker economic environment.

The economy ended 2018 on solid footing. GDP growth remained firm in the third quarter despite a small downward revision.

Holiday shopping likely exceeded expectations and economic growth during the fourth quarter should be in the 2.5 percent to 3 percent range.

The labor market remained tight with job growth persisting despite dwindling pools of labor and some modest wage pressures. Consumer and business confidence remained at elevated levels, spurred by the passage of tax reform. Even the housing market, which has struggled to recover from its massive implosion during the Great Recession, looks finally to break out of its slumber. New home sales grew by nearly 18 percent year-over-year while existing home sales grew by its fastest pace since December 2006.

Business and personal tax cuts should also boost economic growth relative to last year.

That acceleration in growth should serve as a catalyst for continued hiring, pushing down the unemployment rate and applying upward pressure to wages.

Economists have overestimated the natural rate of unemployment (the level above which inflation does not increase) during the current expansion. But continued declines in the unemployment rate below 4 percent, from its current level of 4.1 percent, would likely push the economy past the natural rate. Beyond that point, quicker wage growth and inflation should emerge.

Just how much quicker remains to be seen. In the past, inflation has been propelled by random, temporary factors that did not signal the start of a trend. Viewed through this lens, the acceleration in core inflation in 2016 looks random – inflation in 2017 should only be marginally higher than inflation in 2015. But, unprecedented late-cycle stimulus could become just the catalyst to start a trend. The Fed will certainly watch unemployment closely, looking for signs of an upward trend in inflation.

As goes inflation…

We currently forecast modest upward pressure to core inflation in 2018, roughly 50 basis points above 2017. That level of inflation should translate into three rate hikes of 25 basis points each and modest upward pressure on the long end of the yield curve. Modest deviation from that level of inflation should not have much of an impact. But the rotation among voting members of the Fed should turn the committee more hawkish this year. How they will respond to a more meaningful deviation from our inflation baseline remains to be seen, especially if a true upward trend in inflation emerges that could persist into at least 2019.

Nonetheless, we see little risk to the economy in 2018 and the current expansion should become the second-longest on record by April. The probability that this expansion becomes the longest on record (which would occur in mid-2019) remains high. We continue to believe that risk of a slowdown will not increase until the latter half of 2019 into the first half of 2020 once interest rates are higher (by as much as 125 to 150 basis points relative to levels now) and growth slows as the effects of the stimulus become part of the economic base. That scenario should play out even if inflation does not unexpectedly accelerate. The Fed will continue to increase rates while the labor market remains tight, looking to get ahead of inflation. The cumulative impact of continued rate increases remains the likely culprit for the next recession, which has often been the case in the post-war era. That often prompts the question, "Why does the Fed raise rates if they could bring about the next recession?" If the Fed fails to raise rates as the economy and labor market continue to tighten and eventually overheat, the resulting recession would be worse and take longer to recover from a relatively mild Fed-induced recession.

What does it mean for CRE?

The economic environment should remain broadly conducive to healthy CRE fundamentals. Accelerating economic growth should underpin net absorption, even at this relatively late stage of an economic expansion. Asking rents should continue to grow while the economic outlook remains favorable. The key challenge to continued downward pressure on vacancy rates remains new construction. But that continues to be a localized and not a national phenomenon.

For CRE capital markets, ongoing economic improvement should help keep cap rates in check, even in the face of rising interest rates. And with the tax legislation issue settled, a key obstacle for investors was removed. Improved policy transparency should help transaction volume in 2018, even if it cannot entirely make up all of the ground lost during 2016 and 2017.

What we are watching this week

The employment situation for December should show another strong month of gains, with a net increase of roughly 200,000 jobs. Wage growth and the unemployment rate likely did not change much. These metrics will be under the microscope in 2018. The ISM Manufacturing and Non-Manufacturing Indexes both likely increased in December, reflecting the broad growth evident in other economic data.

Thought of the week

Energy prices, already expected to rise 12 to 18 percent this winter, could increase even faster due to the prolonged below-average temperatures across most of the country.